I don’t accept the assumption that risk is well understood in financial markets. That the risks are just priced in.  I don’t think risk is nearly as mathematically quantifiable as the many financial engineers, hedge fund managers, and quant funds managers argue.  While I’ll admit I don’t understand much of the math behind the PhD’s risk management theorems I read enough econ white papers to have a vague enough idea to recognize many of the assumptions enabling this math.  Many of the assumptions are so large that it makes the whole mathematical exercise mute.

Calculating risk is still more art than science which is largely being proved out by the failure of Moody’s and banks to accurately gauge CDO and CLO risk. Moody’s and others just follow trend lines. As Egan Jones has asked, when have the major bond rating firms ever anticipated a market inflection point?  In addition, the lack of transparency exacerbates the problem.  On top of that I-bankers and analysts are paid annually so they are rewarded if years of investor’s profits are eventually destroyed through bankruptcy. 

Greenspan had one great call (understanding productivity was dramatically increasing) and one horrible call (exuberantly supporting OTC derivatives and dramatically increased leverage). The increased leverage was justified by the financial engineers’ fancy new models that were just assumed to work; but have now been refuted. So what has happened? The financial engineers just adjusted the models to the new trend lines.

Many financial parties break risk down to nearly a purely mathematical equation.

• Quant funds (e.g. Goldman claiming two consecutive days of 10 standard deviation events)
• Hedge funds (e.g. Citadel whose computers often account for more than 10% of daily U.S. listed equity options contract volume)
• Ratings firms (e.g. Fitch’s models for MBS’s did not account for falling house prices…prices never decrease?)

These models never anticipated the apparent shock of the housing bubble. Even though the cover page of every magazine at Barnes and Noble exclaimed the current housing bubble, but the models did not see it. Risk will always be much more than a mathematical equation. We don’t need better math or better data; we need better analysts.